From Basel 2 to Basel 3

1. From Basel 2 to Basel 3 Sergio Lugaresi, Public Affairs Milan, October 26, 2012

2. The Agenda Summary Washington 2008: supervision, compensation, securitisation London 2009: Basel III, taxes Pittsburgh 2009: large global financial firms (then SIFIs) Seoul 2010: shadow banking The next step: Consumer Protection? Conclusions 2

3. Summary • From Basel II, an “International cooperation based on home country control” (Kapstein 1994), to “international cooperation based on host country control and peer review” with a central role played by the Financial Stability Board (FSB) • The focus has shifted from the immediate culprits of the financial crisis (supervision, compensation, securitisation) to repair and innovation of prudential regulation (Basel III). The evaluation of its economic impact has been very controversial. • Taxpayers concerns have played an important role. 3

4. Introduction: Basel 1 (1988) • The core prudential regulation is based on international Accords signed by major financial regulators in Basel. • The first Accord (Basel I) had been signed in 1988 and had introduced a common minimum capital requirement of 8 percent of Risk Weighted Assets (RWA). • RWA were to be calculated by applying pre-determined weights (ranging from 0 to 100% based on the nature and geography of the counterparty) to exposures. Off-balance sheet items were to be included using a conversion factor. • Despite its success in halting the historical downtrend in bank capital ratio, Basel I was soon object of criticism for neglecting interest and market risks and for the arbitrariness of the weights that generated incentives to regulatory arbitrage (i.e. to bias lending to counterparties with risk disproportionate to their weight).

5. Basel 2 • In 1996 Basel I was amended to include an explicit capital requirement for market risk to be calculated, at least for larger banks, from banks’ internal models conditional to their validation by supervisors. These internal models are based on the Value-at-Risk (VAR) methodology which identifies risk with volatility (measured by its standard deviation) and assumes a normal distribution of returns. • Basel II (2004) introduced two main changes: • it substituted the fixed weights extending the possibility to use external ratings and internal models; • it complemented minimum capital requirements with principles for supervision (Pillar 2) and transparency to strengthen market discipline (Pillar 3). • The internal credit risk models were to be based on the same approach, namely the “asymptotic single risk factor” (ASRF) model developed by Gordy (2003), which assumes normally distributed probability of defaults and an unique factor of macroeconomic risk. • Large banks are supposed to estimate all the relevant parameters, i.e. the probability of default (PD), the loss given default (LDG), i.e. the percentage loss occurring after default, and the correlation to the single macroeconomic factor. • In 2007 Basel 2 was going to be fully implemented in the EU, but not yet in the US.

6. Global Committee Structure – A Regulator’s View G20 (Finance Ministers and Central Bank Governors ) IMF World Bank (Governments) Spain OECD (Governments) IASB (Accounting) US FASB (Accounting) CGFS Financial Stability Board Bank for International Settlement (Central Banks) CPSS Basel Committee on Banking Supervision IOSCO (Securities) IAIS (Insurance) G10 (Central Banks) Joint Forum

7. Abbreviations • CGFS: Committee on the Global Financial System • CPSS: Committee of Payment and Settlement Systems • FASB: Financial Accounting Standards Board • G10: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, UK, USA • G20: Argentina, Australia, EU, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, Korea, Turkey, UK, USA • IAIS: International Association of Insurance Supervision • IASB: International Accounting Standard Board • IMF: International Monetary Fund • IOSCO: International Organisation of Securities Commissions • OECD: Organisation for Economic Cooperation and Development • WTO: World Trade Organisation

8. Washington: November 2008 • The G20 initially focused on the need to improve supervision, both nationally and internationally, and to address the issue of pro-cyclicality (including compensation practices) in financial market regulation. The Action Plan agreed by the G20 leaders (Washington, Nov 2008) reflected these priorities. An emphasis was also given to enhancing transparency and promoting financial market integrity. 8

9. Supervision • Main actions at the EU and US level • The new European financial supervision architecture (following the De Larosiere Report): • The Dodd-Frank Act • Strengthened the supervisory role of the FED • Financial Stability Oversight Council (FSCO), stronger than the ESRB 9

10. Supervision: EU Reform In November 2008, EU President Barroso appointed a High Level Group, chaired by Jacque de Larosiere, with the aim of proposing a reform of the European financial supervision and regulation • The Group, inspired by a strong Europeanism impulse, published its 30 recommendations in February 2009. The recommendations addressed the three main issues: • A new supervisory framework in Europe: • A broad review of the Basel II prudential rules: • A new crisis management and resolution framework: • In September 2009, following a public consultation, the Commission issued its proposals: to establish a macro-prudential European Systemic Risk Board (ESRB); and replace the existing consultative Lamfalussy Committees with new European Supervisory Authorities (ESAs) for the banking (European Banking Authority – EBA), insurance (European Insurance and Occupational Pensions Authority - EIOPA) and securities sectors (European Securities and Markets Authority - ESMA). • The political agreement reached by the three EU negotiators – Commission, Parliament and Council - was approved by the ECOFIN Council on 7 September 2010 and by the EU Parliament on 22 September. The reform came into effect on 01/01/2011. • The ESA’s powers are substantial. They will generally decide according to the majority rule and take binding decisions. • Specifically for the banking sector, the EBA will establish a single rulebook and interpretations and have the power to directly address a bank in cases when the national authorities fail to implement the rulebook. It will be a full participant in colleges of supervisors with the power to settle differences between national supervisors. Furthermore, EBA will have a key role in crisis management and in the development of cross-border banks’ Recovery and Resolution Plans. • The reform was clearly a compromise. However, it is a good compromise, in part due to the role of the European Parliament. It was the EP’s first test, under the Lisbon Treaty, and with a new Commissioner for the Internal Market, Michel Barnier. 10

11. Pro-cyclicality and Compensation • On 2nd April 2009, the FSB published its “Principles for Sound Compensation Practices”. • On July 2010, the European Parliament approved new remuneration rules in the Capital Requirements Directive (so-called CRD III). • The new regulation regards Var. vs Fixed, Annual vs deferred, cash vs equity, Deferral period, Retentionof equity or equity-linked instruments 11

12. Credit Rating Agencies • Ratings have proved to be backward-looking and procyclical. • The reason for this procyclicality are: • Flaws in the mathematical models designed to estimate default probabilities, in particular to catch innovations and system breaks (common to other mathematical models); • Conflicts of interests arising from the combination of oligopoly, the “issuer pay” model prevailing since the 1970s and the huge size and concentration of investment banking since the 1990s (oligopsony). As a consequence CRAs tend to maximize their market share (and thus their short-term profits) at the expense of accuracy and long term reputation; • CRAs do not have legal responsibilities. • Credit rating agencies subjected to oversight (CRA EU Directive); • The main objectives of the Commission proposed new regulation are to be supported, namely: • Lower reliance on ratings; • Lower conflict of interests • More transparency; • More accountability. • However, some features of the Commission proposals are not satisfactory. In particular the compulsory rotation, aimed at increasing competition, may be costly and ineffective. • The commission proposals fail to lower regulatory reliance on ratings, which is however embedded in risk-based prudential requirements. The CRAs sector should be carefully assessed by the European Competition Authority and public policies aimed at favouring entrance of new players. Investment banking concentration may be discouraged by SIFIs regulation, but encouraged by ring-fencing. 12

13. Transparency and Financial Market Integrity: Securitisation • The authorities’ interest focused on the financial markets during and after the crisis. • After the markets froze in 2008, issuances were mainly retained as eligible collateral for central banks. An important source of private bank funding has therefore ceased to function. • Authorities’ attitude with respect to the securitisation market has been ambiguous: on the one hand, authorities recognize that securitisation provides an innovative tool to reduce risk and diversify portfolios; on the other hand, it is seen as one of the main culprits of the financial crisis - overly-complex, a risk diffuser and distorting incentives to assess creditworthiness properly. • The authorities have taken several measures to adjust regulation in the securitisation market. • compulsory 5% retention rate on securitised risks (“skin in the game”); • The European central bank launched the loan-by-loan initiative (a database with micro data on securitised loans) to enhance transparency. 13

14. London: April 2009 • As the financial crisis evolved, governments became increasingly more focused on the deteriorating fiscal situation as a result of public intervention to support the financial sector. Following the G20 London Summit, the Basel Committee on Banking Supervision (BCBS) started to set out new prudential requirements (Basel III) for consultation at the end of that year. However, as time was needed for consultation, impact assessments and to reach international consensus, some governments became impatient to address taxpayer concerns of their immediately. A new set of financial system contributions and taxes were put on the agenda . 14

15. Basel III • Under pressure from continental European governments, the G20 Leaders Summit set a target: to “improve the quality, quantity and international consistency of capital in the banking sector”. • On 17th December 2009 the Basel Committee published “Strengthening the resilience of the banking sector” for consultation. It covered: • a new capital definition; • counterparty credit risk (CRR); • a countercyclical buffer; • liquidity ratios; • a leverage ratio. • The initial proposals were quite strong and raised concerns about the impact on the real economy, particularly in Europe, where banks intermediate a large share of private savings. • The Basel Committee announced a final set of standards on 12 September 2010. They were endorsed by the G20 Leaders in November 2009. National implementation will begin in 2013. In order to avoid a negative impact on economic recovery, transition periods lasting until 2019 were set out. 15

16. Basel III decision making Financial Stability Board IMF World Bank (Governments) 2 report 1 G20 Leaders Summit Bank for International Settlement (Central Banks) Macroeconomic Assessment Group (MAG) report 4 1 August 2010 3 Proposals and QIS 2 September 2010 G20 (Finance Ministers and Central Bank Governors ) 3 October 2010 Basel Committee on Banking Supervision 2 4 November 2010

17. CRD IV decision making 1 2 December 2010 4 By December 2011 5 By end 2012 Basel Committee on Banking Supervision (includes EU) Ecofin Basell III approved by G20 (which includes EU and BCE) 1 2 4 National Parliaments codecision 3 European Commission Trialogue CRD IV 5 1 QIS 2 Banca d’Italia BaFin FSA… European Parliament CEBS/EBA 5 Guidelines/ Rule book

18. Basel 3 main changes on Core Tier 1 ratio Basel 2 Basel 3 Increase of the minimum Higher deductiosn Not explicitely defined Core Tier 1 capital Defined both minimum and target Min 2% (3,2% for Italy) Min 4,5% Target 7% Increase of requirements for counterparty risk (market risk already in CRD III) RWA based on internal model RWA RWA based on internal model

19. Which capital targets beyond Basel 3? Pillar 2 Pillar 1 Common Equity ICAAP process Stress test MInimum 4,5% Minimum plus conservation buffer 7% + Common Equity? Countercyclical buffer 0% -2.5% Additional common equity requirement + Additional loss absorption capacity Contingent capital ? Capital surcharge for SIFIS Debt bail-in

20. BIS 3 Implementation: Regulatory Timeline Despite the lack of a definitive rule-book, the focus of attention has already shifted to implementation as new and substantial reporting requirements take effect very soon (end of 2012) December 2011 December 2012 December 2013 December 2014 QIS REGULATORY REPORTING to be promptly translated into Regulatory Reporting requirements at national level (new segnalazioni di vigilanza) in June 2012 EBA is expected to issue its Binding Technical Standards Introduction of New Deductions (Minority, DTA,..) REGULATORY CAPITAL Introduction of Common Equity Start of Monitoring Phase LEVERAGE New Rules in place CCR Start of Monitoring Phase LIQUIDITY

21. The Economists’ Debate on Basel III • The “bank” critique. (Jacques De Larosiere). Excessive capital requirements and the introduction of liquidity ratios and a leverage ratio will increase banking costs and reduce bank profitability. This will bust migration of certain financial activities into the unregulated shadow banking system and encourage banks to seek for higher returns taking more risk and reduce activities with modest margins such as lending to small and medium-sized enterprises. At the end the financial system will be not more stable but economic growth will suffer. The European economy, which is more bank dependent, will suffer the most. Effective regulation requires, instead, competent and efficient on-the-ground supervision. • The “academic” critique, which has been summarised in an FT article signed by several outstanding financial economists (including Frank Allen, John Cochrane, Charles Goodhart, Eugene Fama, Markus Brunnermeier, Martin Hellwig, William Sharpe, Anjan Thakor). Basel III is far from sufficient. According to this view higher capital requirements will not increase funding costs: higher cost of equity will be compensated by lower cost of debt (the abused Modigliani-Miller theorem). The substitution may be not perfect because of the tax bias in favour of debt. This bias should be removed. Taxes to pay for guarantees are not a solution, as they increase moral hazard. The system of determining required equity levels through a system of risk weights (Basel 2 and 3) encourages “innovations” to economise on equity, which undermine capital regulation and often add to systemic risk. Therefore, a better solution would be to impose a leverage ratio (defined as equity over non-risk-weighted assets ) not lower than 15% (Basel introduce for observation a Tier 1 leverage ratio of 3%). 21

22. Taxes and Contributions • As the BCBS’ work on Basel III was proceeding (consultations and impact assessments), US government could not delay addressing taxpayer concerns. • At G20 request, possible financial sector contributions were presented in an IMF report to the G20 Summit (Toronto, June 2010). The IMF proposed two sets of measures: • a Financial Stability Contribution (FSC) to reach a level approximately 2%-4% GDP. The tax base should be liabilities excluding equity and insured deposits. The proceeds of a levy could finance a resolution fund or feed into the general government budget. If the option was for a fund, the IMF supports a pan-European Fund. • a Financial Activities Tax (FAT) on banking rents (i.e. the sum of profits above “normal” levels and high remuneration) to offset favourable treatment under existing VAT and mitigate excessive risk-taking. • The authorities try to justify more financial sector contributions with four main arguments in: • ensure the financial sector pays for expected net fiscal costs of direct support; • possible, indirect contribution to financial sector stability by dissuading certain risky activates while, at the same time, being a revenue source; • the financial sectoris seen as the main culprit for the crisis and its negative effects on government debt; • most financial services are exempt from VAT and this generates incentives to over-consume financial services and depress tax revenue. • Taxes have been introduced in several countries (UK, Germany, Austria etc., not in USA) and the EU Commission is working on harmonising at the highest level the deposit insurance contributions. 22

23. Issues for Discussion • What could have been the alternatives?: simple rules (leverage ratio, ring fencing, international Treaty on cross-border banks) • The financial reform is a mix of innovation (leverage ratio, liquidity, resolution, macro-supervision) and tentative repairs (prudential supervision, capital requirements based on risk weights). • A common framework for the impact assessment is still missing: Behavioral responses, biases, interaction with policies are topics to be addressed. • Implementation over the next eight years at the national level with peer review: will it work? How to solve conflicts between national authorities? The EU is a laboratory. Will the FSB gain more power? • Basel III set minimum standards. Will it be overcome by national rules (China 10,5%, Vickers)? • Different accounting rules remain the main source of regulatory disparities • Bank size remains an issue and the development of global players is jeopardized. Will this lead to Macro-jurisdictions? 23

24. References • Carmassi, Jacopo – Micossi. Stefano, Time to Set Banking Regulation Right, CEPS, 2012 • Veron, Nicolas, Financial Reform after the Crisis: and Early Assessment, Bruegel, 2012 24

25. Next • Th. 11 Oct. h 10.30-12.15, aula 3 1. Introduction. Cross-border banking and regulation • Wed. 17 Oct. from 14.30 to 16.15, aula seminari 2. Prudential Regulation: Lessons from the Crisis • Fri. 26 Oct. h 10.30-12.15, aula 3 3. From Basel 2 to Basel 3 • Thu. 8 Nov. h 10.30-12.15, aula 3 4. Moral hazard • Thu. 15 Nov. h 10.30-12.15, aula 3 5. Shadow Banking • Thu. 22 Nov. h 10.30-12.15, aula 3 6. Rules and supervision • Thu. 29 Nov. h 10.30-12.15, aula 3 7. Crisis Management and Resolution • Thu. 6 Dec. h 10.30-12.15, aula 3 8. Overall assessment of the regulatory reform • Thu.13 Dec. h 14.30-16.30, aula 20 9. The Euro debt crisis and the Banking Union • Mon.17 Dec. 10.30-12.15, aula seminari 10. Wrap-up and conclusion 25